Yuan Suddenly Devalued by 2%: Is It (Currency) War?

August 11th, 2015 by

Yuan Mao shown on a Chinese currency note.

Yuan Mao shown on a Chinese currency note.

The Chinese government uncorked a shocker of a move today, when it suddenly devalued the renminbi (yuan) by over 1.9%. This is the largest drop in the value of China’s currency in over 20 years, causing global markets to reel.

A continuing decline in exports and domestic demand apparently forced Beijing’s hand. While not officially pegged to the U.S. dollar, the Chinese government manages money supply to keep the RMB-USD exchange rate in an “approved” range of 2% to either side of the official daily “fix” issued by their central bank. The large rally in the dollar had dragged the yuan along with it, due to China’s policy of a “soft” peg, and was hurting Chinese exports. Those exports fell by over 8%, y/y, last month, more than 4 times the expected rate. The new, weaker yuan will not only help Chinese exports, but help domestic companies compete with the now more expensive imports from the West.

The Immediate Effects of Yuan Devaluation

Stock markets around the world fell on the news of the surprise devaluation, especially those of major suppliers of raw commodities to China. The currencies of those exporting nations were also hard hit. German and U.S. bonds saw safe haven inflows, sending yields lower. Raw commodities, which had gained a brief respite on Monday, were hammered mercilessly, while gold jumped $15 on the news.

The U.S. dollar initially jumped, but lost ground in Europe as the euro common currency gained. News of a deal being reached in the Greek debt crisis, and EUR:CNY carry trades being dropped both contributed to a gain in the EUR.

Market Reform or Currency War?

yuan-vs-dollar

The Peoples Bank of China, China’s central bank, said that the massive devaluation of the yuan was a one-off event to bring the currency closer to true market value. Going forward, it said, the morning fix would be based on the previous day’s closing price.

China has been striving to have the yuan included in the IMF’s Special Drawing Rights (SDR) basket, which is composed of the world’s leading reserve currencies. In order to qualify, the yuan must be freely convertible, and used in a substantial amount of international trade. The government’s “soft peg” of the yuan to the dollar of course defies that first rule. Today’s devaluation and announcement of market-driven benchmarks may serve to salve the IMF’s concerns on this front.

The move naturally ignited renewed chatter in the financial press about “currency wars”, but others say that China’s hand was forced by the monster rally of the U.S. dollar. Since Beijing had been keeping the yuan steady compared to the dollar, the rapid rise of the greenback had pulled the yuan out of alignment with the currencies of the rest of the world. This was hurting exports. One expert was quoted by Fortune as saying that if China was intent on starting a currency war, it would have devalued the yuan by at least 20%.

China wants the yuan to be seen as a strong currency, to make it more likely to be included in the IMF SDR basket (which would be a huge mark of international respect.) But the too-fast rise in the currency was causing deflationary pressures to build, and China has no intention of going through a “Lost Decade” like its neighbor japan has suffered.

But, Can Beijing Keep Its Finger Out of the Pie?

Some traders are skeptical over China’s claim that today’s devaluation is a one-time event, and that it will let market forces determine the yuan’s exchange rate. One only has to look at recent promises of the same thing in the stock market, and Beijing’s heavy-handed intervention to prevent a crash by having government agencies buy $800 billion in stocks (something even the Fed would recoil from).

The Chinese now need to walk a tightrope of a too-strong yuan causing deflation, and a too weak yuan causing capital flight. Capital outflows have already been a problem for several months, either from wealthy Chinese moving their fortunes offshore, or a waning appetite of foreign investors for Chinese stocks.

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